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The Relationship Between Guaranteed Income and Safe Withdrawal Rates

Spending from your portfolio in retirement is always a balancing act between two competing goals:

  1. Minimize the likelihood of depleting your portfolio during your lifetime (i.e., don’t overspend), and
  2. Have as high a standard of living as possible (i.e., don’t underspend and end up with a giant pile of unspent money when you die).

In a recent paper David Blanchett of Morningstar looked at how that balancing act is affected by the portion of your spending that comes from guaranteed sources (e.g., Social Security, pension, lifetime annuities) as opposed to from a portfolio of stocks/bonds with unpredictable returns.

If your spending is primarily portfolio-funded (rather than coming from guaranteed sources), you cannot afford to take significant risk of depleting the portfolio. That is, Goal #1 (don’t overspend and deplete your portfolio) is so much more important than Goal #2 (don’t underspend) that you can’t really afford to think about Goal #2 very much. Conversely, if your overall spending is funded primarily by guaranteed sources, then Goal #1 becomes less important relative to Goal #2 and the “just right” rate of spending from your portfolio is going to be higher.

A lot higher, as it turns out. Here’s one of Blanchett’s findings:

“Results from this analysis suggest that optimal initial safe withdrawal rates varied significantly when guaranteed income was considered, from approximately 6 percent when 95 percent of wealth was in guaranteed income, versus approximately 2 percent when only 5 percent of wealth was in guaranteed income.”

In other words, holding all of the other variables constant, it’s reasonable for a person with a very high level of guaranteed income to spend from their portfolio at roughly three-times the rate of a person with a very low level of guaranteed income.

An important takeaway here is that if you are basing your own spending rate upon one or more specific pieces of “safe withdrawal rate” research, you should check that their assumptions are a good fit for your own personal circumstances. Does the research demand a higher (or lower) level of safety than you require given your own circumstances?

Another important point is that this factor (i.e., the percentage of your spending that comes from guaranteed income sources rather than from a stock/bond portfolio) is under your control to a significant extent. If you want to increase your level of safe income, you can delay Social Security and/or purchase a lifetime annuity with part of your portfolio. These are not things that everybody should do. But they do meaningfully increase the amount you can safely spend per year, because:

  1. The payout on the part of the portfolio that gets annuitized (or the part that gets spent down to delay Social Security) is higher than the safe withdrawal rate from a stock/bond portfolio, and
  2. As Blanchett discusses in the paper, your safe withdrawal rate from the rest of the portfolio can now be higher because it’s less problematic if the portfolio is ultimately depleted.

To be clear though, while this one factor does have a big impact, it’s not the only thing influencing the appropriate spending rate from a portfolio. The appropriate spending rate also varies significantly depending on:

  • The expected returns from stocks and bonds,
  • Your life expectancy (an 85-year-old can safely spend a higher percentage of their portfolio per year than a 65-year-old),
  • Your flexibility to adjust spending, and
  • The strength of your “bequest motive” (i.e., your desire to leave behind a lump-sum for your heirs).

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